How Allentown Leased Its Utilities to Fund Pensions

Facing an unsustainable rise in retirement fund costs, the Pennsylvania city monetized its water and sewer system, raising millions for pensions and other needs. But the deal has its critics.

September 9, 2013 AT 11:00 AM

Officials in Allentown, Pa. -- like those in many cities -- have been increasingly worried about the growing burden of out-of-control pension costs.

In 2006, they were required to contribute $6 million to their pension plan. By this year, the figure ballooned to $18.5 million, and next year, it was projected to approach $21 million, says Mayor Ed Pawlowski.

"We had done a really good job the last several years of cutting everything we could," Pawlowski says. "We reduced our workforce by 20 percent. But no matter how much we cut, we'd never get out of that scenario." City forecasts indicated that by 2015, required payments into pension funds would equal 30 percent of the general fund.

That presented a serious challenge. The city couldn't raise taxes high enough to pay those costs, the mayor says, so city leaders came upon an idea that others have tried: monetizing an asset. It's not a unique concept, as government agencies have increasingly turned towards steps like privatizing parking garages, roads and other things that have steady funding streams in order to get up-front money.

Initially, Pawlowski says, he and the city finance director explored the idea of privatizing the city's parking authority and municipal golf courses, but neither were going to generate significant enough revenue to deal with the pension issue.

Then, they considered leasing out the water and sewer system. The system has been a moneymaker for the city, but for the most part Allentown -- like many cities -- faced legal prohibitions on transferring revenue from those sources into the general fund. The plan was to seek an upfront lease payment from a private entity, and then use that money to pay down the pension liability.

Pawlowski says the city spent eight months crafting the terms of the lease before soliciting bids, including requirements about hiring existing workers, operations standards, and rate hikes.

But the deal drew criticism from advocates who argue against privatization. Ultimately, when it was put out to bid, Allentown got four bites. But the winner was actually the local Lehigh County Authority, the non-profit water and sewer provider in the region, which beat out the private-sector offers.

In short, Allentown entered a public-private partnership, except in this case, the "private" partner was a public one. Here's how it the deal works.

For 50 years, the LCA will operate, manage, maintain and collect revenue from the city's water and wastewater facilities. In exchange, it gives Allentown $211.3 million up front and $500,000 annually, adjusted for inflation, starting in 2016.

The city will use that money for a variety of purposes, but the bulk of it will go toward its pension funds -- about $160 million -- with another $29.3 million paying down its water and sewer debt. About $15 million will also go into its reserves.

Pawlowski paints it as a great deal for the city. The city shrinks its debt, increases its savings, and brings its pension payments down to a more reasonable level -- all without raising taxes. In FY 2014, the city will contribute about $3 million its pensions, and the state will kick in the same amount. That's dramatically less than what Allentown was paying before.

"We solved a critical fiscal problem that was going to bankrupt us if we didn't address it in the very near term," the mayor says.

Indeed, in May the ratings agency Moody's gave the deal high marks, highlighting the impact it will have on reducing the city's debt. Had Allentown not approved the deal, it would have either had to issue pension obligation bonds or strain the tax base by increasing property taxes by up to 75 percent, Moody's writes. "While the lease may result in higher water and sewer fees within the city, these costs would be borne by a broad base of all rate payers in the city, including non-profit and other entities that do not pay property taxes," Moody's writes.

Then In June, Standard and Poor's, another ratings agency, revised Allentown's ratings outlook from stable to positive, also citing the deal.

But the lease has its skeptics. Bill Hoffman, city controller from 2008-2011, wrote in a column for the local Morning Call newspaper that Pawlowski has overstated the impact of the high payments the city has been making into the pension fund. While those payments are rising, he says they would have started to decline in 2020 as the system comes closer to being fully funded and ultimately they'd fall below present-day levels.

"It seem it's a really complicated way of dealing with a short-term obligation," says Ellen Dannin, a professor at Pennsylvania State University's law school who's studied public-private partnerships. "This is really a long-term way to deal with a short-term problem."

Skeptics have also accused the city of mischaracterizing the nature of the deal. Essentially, the city has taken out a loan from the LCA that will be paid back over the course of 50 years by Allentown business and residents. Those parties will be paying the money via utility bills instead of taxes, but either way, the community is paying for it, and the LCA isn't giving away free money.

The LCA issued bonds to pay for the deal. According to the Morning Call, by the times those bonds expire in 2047, the LCA will have paid $771.2 million in principal and debt. Meanwhile, LCA officials have projected $2.5 billion in revenue in the first 35 years of the lease -- vastly more than what the city's receiving.

Pawlowski says that's besides the point. Before deal, the utility was financially successful yet failed to help improve the finances of the city since the money couldn't be transferred.

"The system makes money," Pawlowski says. "Nobody's denying the fact. What good is it if you can't... utilize it any way, shape, or form to solve the problem that's destroying you?"

"If I have a building next to me that I own, and I have a problem paying my own mortgage, maybe I should rent that building out," he continues.

Some have expressed concern that the deal will inevitably result in higher rates. Under the agreement, rates will be frozen until 2015. Then, from 2016 to 2032, the maximum annual rate hike is inflation plus 2.5 percentage points -- a total of about 5 percent. After that, the maximum rate hike is inflation plus 2 percentage points -- about 4.5 percent.

Pawlowski says that's less than the average annual rate hike over the last 40 years -- about 5.6 percent. But projections by Arcadis, an independent engineer that analyzed the deal for the LCA*, warned of the pace of the rising rates.

By 2022, water and sewer bills will be 20 percent more expensive than if rates just increased at the pace of inflation. By 2042, they will be nearly 100 percent higher than the inflation rate. That's so much that some customers may not even be able to pay their bills, leading to higher delinquency rates. Indeed, in about 15 years, the annual water and sewer bill will be double what it is today, based on those caps, according to Arcadis.

(Update: after this article was published, PFM Group -- which analyzed the deal for the city -- released its own projections. It estimates rates will be 13 percent higher than inflation by 2022 and 66 percent higher by 2042).

Although Allentown joins the same system used by suburban customers, and will use the same water from the same sources, they'll pay a different rate from those suburban customers, which drew some ire in the community.

Moreover, there's a slew of costs that may be imposed on customers that fall outside the rate caps, such as "capital cost recovery charges," "capital recovery fees," and "service charges." Those are extra fees that could be put on customers to pay for infrastructure improvements, costs associated with disasters, and even shortfalls that might result if there's a drop in utility use. "These contracts are put together so the private partner can't lose," Dannin says.

One of the biggest critics of the deal was Food & Water Watch, an advocacy group that generally opposes privatization. The group opposed bringing in a private partner for the deal but it expressed more optimism towards the arrangement with LCA.

"Although this outcome is not perfect, Allentown residents have been saved from rate gouging and other poor practices of the private water companies who bid on their system," the group said in a statement. "It also highlights how private companies just cannot compete financially with nonprofit public entities," it added, citing the fact that LCA can borrow money at lower rates and doesn't have to turn a profit.

This article has been modified to clarify that Arcadis analyzed the deal for the Lehigh County Authority, not the city of Allentown.